What is the crowding-out effect?

• A. A rise in exports due to deficits.
• B. The negative effect of budget deficits on private investment, which occurs because government borrowing drives up interest rates.
• C. The positive boost to private investment from government spending.
• D. The decrease in unemployment due to fiscal deficits.

Answer: (D)

Crowding-out happens when the government borrows to finance a deficit and this borrowing raises interest rates, making private investment more expensive or less attractive. When the government competes for the same pool of savings, the cost of borrowing for borrowers in the private sector increases, leading to a drop in private investment. This is why the crowding-out effect is described as the negative impact of budget deficits on private investment.

The other scenarios don’t fit this mechanism. It’s not about exports rising because of deficits, and it isn’t about a direct positive boost to private investment from government spending, nor about unemployment automatically falling as a result of deficits.